Opinion: Market discipline: an intermittent option
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AIG headquarters in New York (Stan Honda/AFP/Getty Images)
Two days after letting Lehman Bros. Holdings Inc. go bye-bye, the Federal Reserve appears to have switched back into rescue mode. Several websites are reporting that the Fed is poised to buy a controlling stake in tottering insurance giant American International Group in exchange for an $85-billion loan. The difference between the two financial-industry titans? AIG evidently had placed a much, much bigger bet on derivatives than Lehman, which also had been a top-10 player in the market for credit default swaps*. Talk about moral hazards: The key to AIG winning federal help appears to be the degree to which it had underestimated risk in selling swaps that insured ... wait for it ... mortgage-related investments.
The Fed might deserve political courage points for resisting pressure from a number of top lawmakers and both presidential campaigns to let AIG go down the tubes. But its actions are really motivated by fear -- an AIG collapse would dump a huge amount of mortgage-related assets onto a market that already is oversupplied, driving down prices further and causing yet another round of write-downs at banks. This, in turn, could force banks to scramble anew for capital, tightening the credit markets and making it harder for many companies to obtain the money they need to run their businesses. How many more firms would be toppled? The Fed couldn’t predict the answer, and evidently it didn’t want to find out.
A sudden AIG failure could be truly calamitous. But a federal rescue carries a different price: if the derivatives market can put taxpayers at risk, shouldn’t it be regulated? At the very least, shouldn’t there be more transparency and some kind of capitalization standard for swaps? It seems reasonable that if the financial industry wants to be free to innovate, it should be prepared to absorb the losses that result as well as the gains. Once the feds step in, don’t the rules change?
*In a typical credit default swap, Company A would agree to pay off a loan that Company B made to Borrower C if Borrower C defaulted. In exchange, Company B would make payments to Company A. Think of it as a way for Company B to insure itself against a loan or investment going bad. The swap contract would require Company A to put up a certain amount of collateral to cover its potential losses. When credit rating agencies downgraded AIG, those contracts required it to put up more collateral. But it couldn’t persuade investors to put up the money, so it threw itself at the Fed’s feet and begged for a loan.